Your cap table holds the key to a big payoff for all your hard work, but there’s a few mistakes that can really cost you. Avoid these pitfalls to help maximize your equity value.
We help manage thousands of cap tables at Shareworks Startup Edition, so we’ve seen plenty of mistakes that have cost equity holders. Our mission is to help everyone make smart equity decisions. That’s why we have compiled these common cap table pitfalls for founders to avoid.
1. Fully vested founder shares
When you first sit down with your co-founders, everyone has grand visions of the future. But in many cases at least one of the founders will go a different direction for one reason or another.
Hopefully, they will part on good terms but that’s not always the case. Regardless, you do not want a situation where a large equity holder is no longer contributing to the company. So most (if not all) of the founders’ shares should vest over several years.
Vesting simply means that the shares are earned over time. If a founder leaves the company early, he or she must forgo any unvested shares. It’s the same as getting paid every two weeks for a yearly salary. The salary is agreed to upfront, but it is only paid as long as the person continues to work for the company.
2. Failing to file for 83(b) election
If you follow the advice above, and issue founder shares that are subject to vesting, then you most likely will need to file an 83(b) election. This is simply a letter sent to the IRS stating that you’d like to be taxed on your restricted stock on the date the equity was granted, and not on the date that it vests. The 83(b) election affects how you will be taxed when you sell your equity.
If you fail to file an 83(b) election within 30 days of receiving the grant, you will be taxed at your applicable ordinary income tax rate upon sale of the stock. Ordinary income tax rates vary based on each individual’s tax bracket, but it most likely falls somewhere in between 35% and 40%.
However, if you do file the election within 30 days of the grant date, proceeds from the sale of the stock will be taxed at the capital gains rate (if you’ve held the stock for at least a year), which is currently 20%. In other words, a proper 83(b) filing cuts the taxes almost in half if you sell the stock a year or more after receiving it. Depending on the value of the stock, the money you save could be a very large amount.
So don’t skip this one. It’s extremely important. The instructions for filing an 83(b) election are pretty straightforward. But you’re always better off working with a qualified tax accountant to make sure you check all the boxes.
3. Failing to correctly analyze the impact of a financing round
Many founders don’t take the time or simply don’t know how to correctly model the impact of a new round of preferred stock or convertible note.
You’ve probably encountered terms like liquidation preference, participation rights and participation caps. If you don’t know what these terms mean, you should take the time to learn how preferred stock affects the value of your equity. Many entrepreneurs have unknowingly given up too much value (through ignorance or by mistake) when negotiating terms.
Convertible notes can be tricky too. These instruments (like KISS notes and SAFE notes) have provisions like conversion caps, conversion discounts, and warrant coverage, which can sometimes mask how much dilution will actually result from the conversion. If you opt to raise money this way, you must take the time understand convertible debt and how it affects your cap table.
You can know exactly how a potential financing round will affect the cap table if you have the right tools. There are plenty of spreadsheets out there to help you model things out, like this one by CB Insights. You can also create a free startup edition account to easily analyze different scenarios and combinations of terms to see how the cap table is affected.
4. Exercising your options too late
Incentive stock options (ISO’s) can provide option holders with favorable tax treatment. When the options are exercised, an employee pays no taxes. Instead the tax is paid upon sale of the stock.
This means that if the stock is held for over a year, the holder will pay long-term capital gains taxes. Long-term capital gains are taxed at a lower rate.
However, taxes will be higher if vested options are exercised when the company is sold. Since the holder will receive immediate income upon exercising, they will pay ordinary income taxes. Ordinary income tax rates vary based upon the holder’s tax bracket, but it’s usually at least 35%.
One additional note: In order to qualify for long-term capital gains – the sale of stock must also be at least two years from the grant date of the original option.
5. Failure to negotiate for early exercisable options
As mentioned above, if you exercise your options too late, you miss out on favorable tax treatment. And if your options are not early exercisable (early exercisable means you can exercise unvested options into restricted common stock), you might not even have a choice.
For example, suppose 25% of your 100,000 options are vested as of today, and your company has a good chance of exiting in the next year or two. If you decide you want to exercise now in order to get favorable tax treatment, you’ll only have 25,000 shares that qualify. You can continue to exercise shares as they vest, but at some point, you’ll start exercising within the one year window, and those shares will be taxed at a higher rate.
Conversely, if your options are early exercisable, you can exercise all your options (vested and unvested) at any time. The unvested shares will exercise into restricted stock, meaning you still have to stay with the company to earn those shares. But your shares now qualify for taxation at the long-term capital gains rate if exercised a year or more before exit.
6. Mispriced option grants
IRC 409a regulations require options to be granted with a strike price equal to or greater than the fair market value of common stock. Granting options too low could result in harsh tax penalties for employees, excess costs incurred by the company and hold ups during an acquisition or IPO. Conversely, if you grant options too high, employees will miss out on value they could have received otherwise.
This exercise can seem somewhat subjective, as the valuation of shares in a startup often feels like conjecture. However, the methodology for accomplishing this has more or less solidified over the years. To make sure you do it right, you simply need to obtain a 409a valuation (at least annually) with a reputable valuation provider.
A good valuation firm will be able to provide a valuation that sets the strike price low enough to provide reasonable incentive, yet defensible to audit firms, the IRS and the SEC. If you need a 409a valuation, Shareworks Startup Edition is the best place to get started.
If you are looking for a guide on the process, 409A Valuations: The Data-Driven Guide is the best place to learn.
7. Poor record keeping
When it comes time for equity holders to cash out, the cap table determines who gets what. But the cap table is not simply an excel spreadsheet. It’s a collection of legal documents, agreements and records that tell the story of how ownership in the company has evolved.
So when a team of lawyers starts pouring over your records to determine how proceeds should be distributed, they’re not going to rely on some spreadsheet that’s been passed around over the years. They’re going to dig into all the legal documents to try and rebuild the cap table from the ground up.
For companies with disorganized cap tables, the lawyers often discover errors and missing information. They sometimes find significant differences between the legal documents of record and the spreadsheets that management and investors have been relying on as a representation of their equity. So someone (maybe even a founder) might believe they’re entitled to a certain amount, but end up receiving something significantly different when all is said and done. Not a situation anyone wants to be in.
Hence, you need to keep accurate records and make sure they agree with all the calculations used to model the cap table. Failure to do so can result in equity decisions using inaccurate information and can lead to surprises and holdups when the company exits. Even once a deal is done, most acquisitions put an amount of the proceeds in escrow. This money will be used to resolve any disputes that may arise after the fact, and it comes right out of shareholders’ pockets.
Make sure your cap table is accurate.
8. Taking on too much money too early
The prospect of large rounds and lofty valuations can be enticing, but resist the urge to take on more money than you really need. You can end up losing control of your company to outside investors and risk your entire stake in the company.
This is exactly what happened with GetSatisfaction. The original founder and CEO, who walked away with nothing when the company sold, laments taking a big bet on a large round of financing when his company was still young. He eventually lost control of the company, got pushed out, then wound up empty-handed when the company sold in a firesale.
A large sum of money won’t suddenly make your business viable and worth the valuation implied by the investment. Only positive cash flow will make your business worth anything in the long run.
You basically have two options: 1) swing for the fences with a big round; or 2) raise as you go in smaller increments. There’s no right answer for all situations, but be mindful that a huge raise at a high valuation is not always the best alternative.
9. Using online legal templates instead of a lawyer
The internet is full of blog posts, open source legal documents and pre-built spreadsheets to help you make sense of your cap table. However, none of these things can take the place of a qualified professional. A standard template for an option plan agreement or shareholder agreement can be a great starting point. But if you don’t understand every single component of what you and your shareholders are signing, then you should be working with someone who does.
You will inevitably encounter nuances and legal complexities as your company progresses. In many cases, you don’t know what you don’t know. Only after the fact do you realize that you could have gotten a better deal, or that you violated some regulation, or that you have to pay more taxes because you forgot to file something.
Never underestimate the value of advice from lawyers, mentors, accountants, etc. Don’t be afraid to spend a few hundred or even a few thousand dollars to make sure you get the cap table right. You can put yourself in a much better position by seeking counsel from professionals who know what to watch out for and how to negotiate.
10. Managing your cap table in a spreadsheet
Of course we would list this one, but we have good reason to.
For one, your cap table is much more than a spreadsheet. It encompasses shareholder agreements, vesting schedules, certificates of incorporation, and a host of other information that is legally defined outside the spreadsheet. You could store these documents in the cloud somewhere and add links to them, but that gets messy real quick and is a pain to maintain.
Additionally, spreadsheets are error prone. All it takes is a small typo in a formula somewhere, and the whole thing is off. If you don’t catch it in time, you could make legally binding decisions using faulty information. You also have to keep track of every single transaction, including sales, transfers, and cancellations. Rolling all these things up into a single table becomes very complex and unwieldy. Many people have tried to make elegant cap table spreadsheets, but even the best cap table templates still suck.
This is why we created Shareworks Startup Edition. It helps you manage all your equity in one place without spreadsheets or paper certificates. Issuing shares and recording them becomes one in the same. Your online cap table becomes the official source of truth, and the place where all things cap table get done. Even if your cap table is super simple, there are plenty of reasons to avoid spreadsheets.
This is by no means a comprehensive list of all the mistakes you can make with your cap table. There are so many edge cases and nuances to cap table management, we couldn’t possibly give you all the advice you need in one article.
Cap tables might seem a little overwhelming, but don’t worry. Nobody gets everything perfect. If you can can at least avoid most of these mistakes, then you’ll be headed in the right direction.
About the AuthorMore Content by Hannah Bloomfield